How to buy oil? Here’s what you need to think about to avoid getting burnt

Over the space of a mere two months the price of oil has more than halved in value and are now at their lowest values since the early 2000’s. A cursory look back over that period reveals two periods (early 2009 and 2016) where oil prices plunged to levels close to where we are today, only for prices to more than double in value over the following two years. Tempting to think the same will happen again isn’t it?

There are two main ways that investors can look to profit from a longer term increase in oil prices. Neither are perfect and both involve risks outside of the standard price of oil that you see quoted on Bloomberg or in the press. The main way is to purchase an Exchange Traded Fund (ETF) which aims to track the underlying futures market. The other way is to purchase equity in a company involved with the production of oil (more on that later).

Investment in oil ETF’s has surged in recent weeks as investors (many of them relatively new to commodities) seek to bet on higher crude prices.

Image

Indeed Google Trends shows the biggest spike in interest into “How to buy oil?” since 2016.

Whatever the future holds for oil prices its important to know what you are getting into. While many of the subscribers to Materials Risk will understand what I’m about to outline, I thought it was so important that the risks are made clear up front that I have tried to put all the gory details front and centre.

Why understanding the futures curve is so important to avoid getting burned by Exchange Traded Funds (ETFs)

For direct exposure to commodity prices, investors generally buy exchange-traded products (ETPs) or funds (ETFs). Physical ETFs usually provide exposure to the price of a commodity and are “backed” by the equivalent value of the actual product, stored securely in a vault. Physical ETFs tend to only feature precious metals such as gold and silver. Futures-based ETFs meanwhile use futures or swap contracts to provide exposure without any physical holdings and are the natural and indeed only way to structure an exposure to energy and agricultural commodities.

Investors’ returns may also be adversely affected when the ETF manager sells expiring futures contracts and replaces them with longer-dated ones at a higher price (contango). However, when near term prices are higher than future ones (backwardation), the ETF investor gains when the positions are rolled over.

The shape of this series of future prices is known as the futures curve. A futures curve is described as in “contango” when it is upward sloping and so prices in six months’ time are higher than the spot price. This is also known as a normal curve or a normal market. In general, traders are willing to pay a premium to avoid the costs associated with transporting, storing and insuring a commodity (known as the cost to carry); therefore, the furthest-out contracts are typically higher in price.

The oil market is currently in contango. The nearest actively traded front month Brent contract (June) closed last week (w/e 17th April) at just over $28 per barrel, the July contract at $31.58 per barrel, August at 33.47 per barrel and onwards, each subsequent contract month higher than the previous. Check out Barchart to see how the futures curve for oil and other commodities looks.

In contrast, when the shape of the futures price curve is downward sloping, the futures price of a commodity in say six months’ time is lower than the current spot price, and so the market is said to be in “backwardation”. This is also known as an inverted curve or an inverted market. Cocoa is an example of a commodity currently in backwardation (see here).

If a futures curve moves towards backwardation (also described as a tightening in the futures curve), it is a good sign that the current underlying conditions in a commodity market are getting tighter – either via gradually improving demand or supply problems, or a combination of both. The opposite of which is so when the curve moves towards contango.

The difference between spot and futures prices for a commodity is known as the basis. The price of a futures contract – whether it is above or below the spot price – will converge to the spot price as the expiration date on the contract approaches. This process is called convergence. 

For someone holding a futures contract where the market is in backwardation, the value of their contract will rise to meet the spot price, enabling them to achieve what is known as a positive roll yield, ie, a bit of income from selling one futures contract and buying another. The opposite applies for a trader holding a futures contract where the market is in contango.

While most oil ETFs concentrate on the front month contract, others are focused on contracts further out across the curve. For investors with a longer-term perspective there are oil ETFs that spread positions across the 12-month curve. This diminishes contango roll risk, but importantly though doesn’t eliminate it.

Investing in a basket of energy producers comes with a different set of risks

Investing directly in companies involved with energy is another way of gaining exposure to oil or a basket of different energy commodities. Note that the share price of energy producers are not always correlated with the price of the underlying commodity. Factors such as capital expenditure, government policies (for example, resource nationalism or action on climate), management, balance sheet and accounting practices, unforeseen operational issues (a miners’ strike, for example) and the general appetite among investors can all affect the share price.

Investors should understand what part of the supply chain they are getting themselves exposed to. For example, exploration and development is inherently risky, and even more so for a small poorly funded company in unreliable jurisdictions. On the other hand, a large major will have exposure across different activities (from exploration to retail, from gas and renewable’s to petrochemicals) and may be able to reduce exposure to anyone sector or region, but equally may not be as closely correlated as more focused, less diversified companies.

The message as always is caveat emptor.

Related article: Up in smoke: Why investors in oil companies may reap a climate rebellion dividend

Related article: What is resource nationalism?

Related article: The futures curve is not a price forecast

Related article: Oil prices: The top 10 most important drivers

(Visited 600 times, 4 visits today)